E. Germany's problems to burden new generation

By Alastair Macdonald

BERLIN (Reuters): A decade has passed since the Berlin Wall came down. But the "flourishing landscapes" that then Chancellor Helmut Kohl promised would replace the Communist rustbelt of East Germany are still lurking beyond the horizon.

Now, Kohl's nemesis and successor, Gerhard Schroeder, has accepted that the dream of a boom in the east may be put off for at least another generation by agreeing at the weekend to extend a special fund for subsidies to eastern regions until 2020.

The move, which could hold lessons for broader west European efforts to foster economic renewal behind the old Iron Curtain, was welcomed by some as a necessary prop to end business uncertainty and prevent further decline in eastern Germany.

But critics argue that extending the "Solidarity Pact", which currently adds 5.5 percent to every German's income tax bill, by 15 years beyond a planned expiry in 2004 would prolong a burden on the entire German economy, which is already proving a laggard in its own right in Europe.

"This is good news for the east," Michael Burda, an expert on east German economic development at Berlin's Humboldt University, said of an agreement between the government and leaders of Germany's 16 federal states to pump 306 billion marks ($135 billion) into the east between 2005 and 2020.

"It was a decisive moment and had it gone the other way, it would have been disastrous for the eastern states."

By using the annual funds, which will eventually decline over time, to make good a gap in infrastructure standards with the west, east Germany could hope at least to halt the outflow of the most dynamic elements in its workforce, Burda said.

Nearly 10 percent of east Germans have left the region since the Wall came down in 1989, leaving it with just 15 million out of Germany's total population of 82 million.

"This 300 billion is clearly needed to close the infrastructure gap," said Joachim Ragnitz of the Institute for Economic Research (IWH), one of Germany's six leading economics institutes, which is based in the eastern city of Halle.

The eastern regions currently receive about $20 billion a year from federal funds and from western regions -- in all, equivalent to about 10 percent of federal government spending.

"The new contract between east and west puts a swift end to one or two illusions," wrote commentator Oliver Schumacher in the liberal Sueddeutsche Zeitung newspaper. "It'll take at least a generation before eastern and western states like Thuringia and Hessen can really compete with each other."

"Despite notable local successes, the vision of rapidly flourishing landscapes has been exposed as wishful thinking. That is a painful realization for the German people, most of whom all too gladly believed in a second economic miracle."

Commentator Reinhard Uhlmann, writing in the business daily Handelsblatt, welcomed at least the end to years of uncertainty over how long the subsidy regime for the east would last, giving some long-term clarity for investors.

"The eastern states now have long-term planning guarantees for their budgets and investments," he said.

Administrative changes in the scheme could also cut down on red tape, although the IWH's Ragnitz regretted that more had not been done to oblige the eastern states to direct funds toward infrastructure investment as opposed to current spending.

Business leaders voiced concern, too, about the economic cost of supporting the east. Michael Rogowski, president of the Confederation of German Industry (BDI), called the deal a "costly compromise" and said the planned reduction in transfers over the new 15-year period should have been accelerated.

Urging the east to shrug off any "subsidy mentality", he regretted that it seemed the "solidarity supplement" tax was here to stay for another 20 years -- though Schroeder has not yet detailed how exactly the scheme will be financed.

The conservative Frankfurter Allgemeine newspaper, in a lead article, expressed dismay at the way Finance Minister Hans Eichel had overcome resistance from conservative-led western states, who play a key role in the transfer mechanism for eastern subsidies, by simply offering a bigger slice of federal funding.

"Shoring up a system that offers states no incentives to improve their lot by their own efforts is bound to make losers of contributors and beneficiaries alike," it said.

Allan Saunderson, an economist at Eurozone Advisors in Frankfurt, warned that high taxes risked encouraging already strong net outflows of direct investment from Germany and making firms think twice about operating in the country. High taxes in Germany were holding back growth across Europe, he argued.

"Germany has to reconsider its tax base," he said. "This continuation of the Solidarity Pact is a case in point ... Germany is becoming an economic drag on the euro zone."

The precise cost of the scheme will depend on future governments' budget plans, a fact that has contributed to muting any serious irritation at the deal among western taxpayers.

And so at a tactical political level, analysts said, having assured the east's long-term future subsidies should help secure Schroeder's Social Democrats crucial votes in the electorally volatile region at an election due in early autumn next year.